Chapter Twenty-Two

Firm Supply
Firm Supply
How does a firm decide how much
product to supply? This depends
upon the firms
technology
market environment
goals
competitors behaviors
Market Environments
Are there many other firms, or just a
few?
Do other firms decisions affect our
firms payoffs?
Is trading anonymous, in a market?
Or are trades arranged with separate
buyers by middlemen?
Market Environments
Monopoly: Just one seller that
determines the quantity supplied and
the market-clearing price.
Oligopoly: A few firms, the decisions
of each influencing the payoffs of the
others.
Market Environments
Dominant Firm: Many firms, but one
much larger than the rest. The large
firms decisions affect the payoffs of
each small firm. Decisions by any
one small firm do not noticeably
affect the payoffs of any other firm.
Market Environments
Monopolistic Competition: Many
firms each making a slightly different
product. Each firms output level is
small relative to the total.
Pure Competition: Many firms, all
making the same product. Each
firms output level is small relative to
the total.
Market Environments
Later chapters examine monopoly,
oligopoly, and the dominant firm.
This chapter explores only pure
competition.
Pure Competition
A firm in a perfectly competitive
market knows it has no influence
over the market price for its product.
The firm is a market price-taker.
The firm is free to vary its own price.
Pure Competition
If the firm sets its own price above the
market price then the quantity
demanded from the firm is zero.
If the firm sets its own price below the
market price then the quantity
demanded from the firm is the entire
market quantity-demanded.
Pure Competition
So what is the demand curve faced
by the individual firm?
Pure Competition
Y
$/output unit
Market Supply
Market Demand
p
e
Pure Competition
y
$/output unit
Market Supply
p
e
p
At a price of p, zero is
demanded from the firm.
Market Demand
Pure Competition
y
$/output unit
Market Supply
p
e
p
p
At a price of p the firm faces the entire
market demand.
At a price of p, zero is
demanded from the firm.
Market Demand
Pure Competition
So the demand curve faced by the
individual firm is ...
Pure Competition
y
$/output unit
Market Supply
p
e
p
p
At a price of p the firm faces the entire
market demand.
At a price of p, zero is
demanded from the firm.
Market Demand
Pure Competition
Y
$/output unit
p
e
p
p
Market Demand
Smallness
What does it mean to say that an
individual firm is small relative to
the industry?
Smallness
$/output unit
y
Firms MC
The individual firms technology causes it
always to supply only a small part of the
total quantity demanded at the market price.
Firms demand
curve
p
e
The Firms Short-Run Supply Decision
Each firm is a profit-maximizer and in
a short-run.
Q: How does each firm choose its
output level?
The Firms Short-Run Supply Decision
Each firm is a profit-maximizer and in
a short-run.
Q: How does each firm choose its
output level?
A: By solving
max ( ) ( ).
y
s s
y py c y
>
=
0
H
The Firms Short-Run Supply Decision
max ( ) ( ).
y
s s
y py c y
>
=
0
H
What can the solution y
s
* look like?
The Firms Short-Run Supply Decision
max ( ) ( ).
y
s s
y py c y
>
=
0
H
What can the solution y
s
* look like?
(a) y
s
* > 0:
H(y)
y y
s
*
( )
( )
( )
( )
( )
.
*
i
d y
dy
p MC y
ii
d y
dy
at y y
s
s
s
s
H
H
= =
< =
0
0
2
2
The Firms Short-Run Supply Decision
max ( ) ( ).
y
s s
y py c y
>
=
0
H
What can the solution y* look like?
(b) y
s
* = 0:
H(y)
y
y
s
* = 0
d y
dy
p MC y
at y y
s
s
s
H ( )
( )
.
*
= s
= =
0
0
The Firms Short-Run Supply Decision
For the interior case of y
s
* > 0, the first-
order maximum profit condition is
d y
dy
p MC y
s
s
H ( )
( ) . = = 0
That is, p MC y
s s
= ( ).
*
So at a profit maximum with y
s
* > 0, the
market price p equals the marginal
cost of production at y = y
s
*.
The Firms Short-Run Supply Decision
For the interior case of y
s
* > 0, the second-
order maximum profit condition is
d y
dy
d
dy
p MC y
dMC y
dy
s
s
s
2
2
0
H ( )
( )
( )
. = = <
That is,
dMC y
dy
s s
( )
.
*
> 0
So at a profit maximum with y
s
* > 0, the
firms MC curve must be upward-sloping.
The Firms Short-Run Supply Decision
$/output unit
y
p
e
y
s
* y
MC
s
(y)
The Firms Short-Run Supply Decision
$/output unit
y
p
e
y
s
* y
At y = y
s
*, p = MC and MC
slopes upwards. y = y
s
* is
profit-maximizing.
MC
s
(y)
The Firms Short-Run Supply Decision
$/output unit
y
p
e
y
s
* y
At y = y
s
*, p = MC and MC
slopes upwards. y = y
s
* is
profit-maximizing.
At y = y, p = MC and MC slopes downwards.
y = y is profit-minimizing.
MC
s
(y)
The Firms Short-Run Supply Decision
$/output unit
y
p
e
y
At y = y
s
*, p = MC and MC
slopes upwards. y = y
s
* is
profit-maximizing.
So a profit-max.
supply level
can lie only on
the upwards
sloping part
of the firms
MC curve.
MC
s
(y)
y
s
*
The Firms Short-Run Supply Decision
But not every point on the upward-
sloping part of the firms MC curve
represents a profit-maximum.
The Firms Short-Run Supply Decision
But not every point on the upward-
sloping part of the firms MC curve
represents a profit-maximum.
The firms profit function is

If the firm chooses y = 0 then its
profit is
H
s s v
y py c y py F c y ( ) ( ) ( ). = =
H
s v
y F c F ( ) ( ) . = = 0 0
The Firms Short-Run Supply Decision
So the firm will choose an output
level y > 0 only if
H
s v
y py F c y F ( ) ( ) . = >
The Firms Short-Run Supply Decision
So the firm will choose an output
level y > 0 only if

I.e., only if

Equivalently, only if
H
s v
y py F c y F ( ) ( ) . = >
py c y
v
> ( ) 0
p
c y
y
AVC y
v
s
> =
( )
( ).
The Firms Short-Run Supply Decision
AVC
s
(y)
AC
s
(y)
MC
s
(y)
$/output unit
y
The Firms Short-Run Supply Decision
AVC
s
(y)
AC
s
(y)
MC
s
(y)
$/output unit
y
The Firms Short-Run Supply Decision
AVC
s
(y)
AC
s
(y)
MC
s
(y)
$/output unit
y
p > AVC
s
(y)
The Firms Short-Run Supply Decision
AVC
s
(y)
AC
s
(y)
MC
s
(y)
p > AVC
s
(y) y
s
* > 0. $/output unit
y
The Firms Short-Run Supply Decision
AVC
s
(y)
AC
s
(y)
MC
s
(y)
p < AVC
s
(y) y
s
* = 0.
$/output unit
y
p > AVC
s
(y) y
s
* > 0.
The Firms Short-Run Supply Decision
AVC
s
(y)
AC
s
(y)
MC
s
(y)
p < AVC
s
(y) y
s
* = 0.
The firms short-run
supply curve
$/output unit
y
p > AVC
s
(y) y
s
* > 0.
The Firms Short-Run Supply Decision
AVC
s
(y)
AC
s
(y)
MC
s
(y)
The firms short-run
supply curve
Shutdown
point
$/output unit
y
The Firms Short-Run Supply Decision
Shut-down is not the same as exit.
Shutting-down means producing no
output (but the firm is still in the
industry and suffers its fixed cost).
Exiting means leaving the industry,
which the firm can do only in the
long-run.
The Firms Long-Run Supply Decision
The long-run is the circumstance in
which the firm can choose amongst
all of its short-run circumstances.
How does the firms long-run supply
decision compare to its short-run
supply decisions?
The Firms Long-Run Supply Decision
A competitive firms long-run profit
function is

The long-run cost c(y) of producing y
units of output consists only of
variable costs since all inputs are
variable in the long-run.
H( ) ( ). y py c y =
The Firms Long-Run Supply Decision
The firms long-run supply level
decision is to


The 1st and 2nd-order maximization
conditions are, for y* > 0,
max ( ) ( ).
y
y py c y
>
=
0
H
p MC y and
dMC y
dy
=
>
( )
( )
. 0
The Firms Long-Run Supply Decision
Additionally, the firms economic
profit level must not be negative
since then the firm would exit the
industry. So,
H( ) ( )
( )
( ).
y py c y
p
c y
y
AC y
= >
> =
0
The Firms Long-Run Supply Decision
MC(y)
AC(y)
y
$/output unit
The Firms Long-Run Supply Decision
MC(y)
AC(y)
y
$/output unit
p > AC(y)
The Firms Long-Run Supply Decision
MC(y)
AC(y)
y
$/output unit
p > AC(y)
The Firms Long-Run Supply Decision
MC(y)
AC(y)
y
$/output unit
The firms long-run
supply curve
The Firms Long-Run Supply Decision
How is the firms long-run supply
curve related to all of its short-run
supply curves?
The Firms Long & Short-Run Supply
Decisions
MC(y)
AC(y)
y
$/output unit
AC
s
(y)
MC
s
(y)
The Firms Long & Short-Run Supply
Decisions
MC(y)
AC(y)
y
$/output unit
AC
s
(y)
MC
s
(y)
p
y
s
* y*
y
s
* is profit-maximizing in this short-run.
The Firms Long & Short-Run Supply
Decisions
MC(y)
AC(y)
y
$/output unit
AC
s
(y)
MC
s
(y)
p
y
s
* y*
y
s
* is profit-maximizing in this short-run.
H
s
The Firms Long & Short-Run Supply
Decisions
MC(y)
AC(y)
y
$/output unit
AC
s
(y)
MC
s
(y)
p
y
s
* y*
The firm can increase profit by increasing
x
2
and producing y* output units.
H
s
The Firms Long & Short-Run Supply
Decisions
MC(y)
AC(y)
y
$/output unit
AC
s
(y)
MC
s
(y)
p
y
s
*
y
s
* is loss-minimizing in this short-run.
The Firms Long & Short-Run Supply
Decisions
MC(y)
AC(y)
y
$/output unit
AC
s
(y)
MC
s
(y)
p
y
s
*
y
s
* is loss-minimizing in this short-run.
Loss
The Firms Long & Short-Run Supply
Decisions
MC(y)
AC(y)
y
$/output unit
AC
s
(y)
MC
s
(y)
p
y
s
*
This loss can be eliminated in the long-
run by the firm exiting the industry.
Loss
The Firms Long & Short-Run Supply
Decisions
MC(y)
AC(y)
y
$/output unit
The Firms Long & Short-Run Supply
Decisions
MC(y)
AC(y)
y
$/output unit
p
y
s
*
y
s
* is profit-maximizing in this short-run.
The Firms Long & Short-Run Supply
Decisions
MC(y)
AC(y)
y
$/output unit
p
y
s
*
y
s
* is profit-maximizing in this short-run.
H
s
The Firms Long & Short-Run Supply
Decisions
MC(y)
AC(y)
y
$/output unit
p
y
s
*
y
s
* is profit-maximizing in this short-run.
y* is profit-maximizing in the long-run.
y*
The Firms Long & Short-Run Supply
Decisions
MC(y)
AC(y)
y
$/output unit
p
y
s
*
y
s
* is profit-maximizing in this short-run.
y* is profit-maximizing in the long-run.
y*
The Firms Long & Short-Run Supply
Decisions
MC(y)
AC(y)
y
$/output unit
p
y
s
* y*
H
s
The firm can increase profit by reducing
x
2
and producing y* units of output.
The Firms Long & Short-Run Supply
Decisions
MC(y)
AC(y)
y
$/output unit
The Firms Long & Short-Run Supply
Decisions
MC(y)
AC(y)
y
$/output unit
The Firms Long & Short-Run Supply
Decisions
MC(y)
AC(y)
y
$/output unit
The Firms Long & Short-Run Supply
Decisions
MC(y)
AC(y)
y
$/output unit
Short-run supply curves
Long-run supply curve
Producers Surplus Revisited
The firms producers surplus is the
accumulation, unit by extra unit of
output, of extra revenue less extra
production cost.
How is producers surplus related
profit?
Producers Surplus Revisited
y
$/output unit
AVC
s
(y)
AC
s
(y)
MC
s
(y)
Producers Surplus Revisited
y
$/output unit
AVC
s
(y)
AC
s
(y)
MC
s
(y)
Producers Surplus Revisited
y
$/output unit
AVC
s
(y)
AC
s
(y)
MC
s
(y)
p
y*(p)
Producers Surplus Revisited
y
$/output unit
AVC
s
(y)
AC
s
(y)
MC
s
(y)
p
PS
y*(p)
Producers Surplus Revisited
So the firms producers surplus is
( )
PS p p MC z d z
py p MC z d z
py p c y p
s
y p
s
y p
v
( ) ( ) ( )
*( ) ( ) ( )
*( ) *( ) .
*( )
*( )
=
}
=
}
=
0
0
That is, PS = Revenue - Variable Cost.
Producers Surplus Revisited
y
$/output unit
AVC
s
(y)
AC
s
(y)
MC
s
(y)
p
PS
y*(p)
Producers Surplus Revisited
y
$/output unit
AVC
s
(y)
AC
s
(y)
MC
s
(y)
p
y*(p)
c y p MC z d z
v s
y p
( *( )) ( ) ( )
*( )
=
}
0
Producers Surplus Revisited
y
$/output unit
AVC
s
(y)
AC
s
(y)
MC
s
(y)
p
y*(p)
Revenue
= py*(p)
Producers Surplus Revisited
y
$/output unit
AVC
s
(y)
AC
s
(y)
MC
s
(y)
p
y*(p)
Revenue
= py*(p)
c
v
(y*(p))
Producers Surplus Revisited
y
$/output unit
AVC
s
(y)
AC
s
(y)
MC
s
(y)
p
PS
y*(p)
Producers Surplus Revisited
PS = Revenue - Variable Cost.
Profit = Revenue - Total Cost
= Revenue - Fixed Cost
- Variable Cost.
So, PS = Profit + Fixed Cost.
Only if fixed cost is zero (the long-
run) are PS and profit the same.